1
CHAPTER 1
INTRODUCTION
1.1
Introduction
Financial infrastructure is always considered as the backbone of an economy.
Current economic environment of a country demands a well-functioning financial
system for economic growth and development. Corporate sector and wellfunctioning financial practices play a vital role in the economic growth and
development of a country (Hunjra et al., 2011). Financial strategies and investment
moves are the key approaches for the performance of any company (McConnel &
Servaes, 1990). The aim of this research study is to examine theoretically and
empirically the application of financial practices and their impact on firm‘s
performance as well as the moderating effect of agency cost. Therefore, this chapter
begins with theoretical and empirical role of finance in decision-making (financial
practices decisions) process and explains the relationship between financial practices
and firm‘s performance. Thereafter, this study proceeds to identify the problem,
which directs to the research objectives, research questions, and importance of the
study. Hence, later on, in this chapter, scope, limitations, and outline of the study are
presented.
2
1.2
Background of the Study
In current business conditions, rapid changes, innovations, technology and
globalization are direct to make more competition among firms. Consequently, in
this competitive business environment, profit, growth and survival of a firm depend
upon the innovativeness of the firm (Kannadhasan and Nandagopal, 2008). Thus,
firm can compete with market dynamic conditions only if it has strong financial
position and flexible firm structure (Mathews, 2005). Rational analysts are always
considered markets‘ efficiency while think about the investing and financing
decisions. It believes that markets are always efficient, which raises two questions
here, what will happen if markets are not always efficient? In addition, what will
happen if analysts are not themselves always rational (Baker & Wurgler, 2012)?
Decision related to anything cannot be made in vacuum since decision-making is
very complicated activity. A firm cannot rely only on the complex models and
individual resources, which are not able to provide a good result of investment in
projects (Kannadhasan, 2008). Cognitive psychology of a manager is important in
the analysis of the problem and variables including problems. While solving the
problem, situation of decision-making activity in solving the individual specific
problem is involved, which enlarges the environment as well (Barberis & Shleifer,
2003).
Process of choosing a specific alternative from a number of alternatives in
consideration of their proper evaluation process is called decision-making
(Scholleova, Fotr & Svecova, 2010). Therefore, managers should update themselves
in multidimensional meadows, if they want to accomplish their desired goals or
results in the competitive environments of businesses (Slovic, 1972). It is also
necessary to understand the human nature (better insight of human in existing global
perception, development skills and ability to generate best from investments) for the
achievement of desired future goals of a firm. Moreover, for investors, it is vital to
develop drive, foresight, preference and positive vision (Tversky & Kahneman,
1974). Various demographic factors (e.g. socio-economic background, age,
education level, sex and race) differentiate one investor from another in many aspects
and investment decision becomes a challenge for them (Kahneman & Tversky,
3
1979). In investment decision, investors should keep in mind their risk tolerance
level, financial goals and other constraints. In addition, an optimum decision of
investment can play a significant and active role in their choices (Archer &
Ghasemzadeh, 1999; Combe, 1999; Bridges, 1999; Sommer, 1999; Cooper et al.,
2000). Optimum investment process is valuable for intuitional investors and not
suitable for individual investor who is vulnerable to behavioral prejudices. In the
past, investment decisions were based on forecasting, market timing and
performance, because the major aim of an investment is to make wealth. In addition,
investors were not fully satisfied and made little profit from investment due to
ordinary outcomes of investment (Kıyılar & Acar, 2009). The existing gap between
desired results and actual results forced them to investigate and find out the reasons
behind these outcomes. In the investigation process, it is found that fundamental
mistakes (irrational investment decisions) in decision-making process are behind
these results. It is realized that the behaviour of decision-makers is important for
avoiding such mistakes, which can create a barrier in better investment decisions
(Kannadhasan, 2008). However, in order to explain the various investor behaviors in
financial markets, it is necessary to understand the corporate culture, financial
practices and their impact on performance.
Corporate sector has a significant role in the economy of any country because
it is responsible for the decisions regarding production of services and goods that
enhance the capacity of production as well as the profit (Hunjra et al., 2011). In
addition, finance strategies and investment moves are the key factors in the
performance of any corporation. Therefore, proper management of financing and
investment activities are more important in enhancing the return of shareholders
(McConnel & Servaes, 1990). Application of financial practices and their role in the
development of corporate sector has been discussed in financial literature, and most
of these studies focus on the developed countries. McCaffery et al. (1997) reviewed
the application of these practices in the UK retailing sector. Hunjra et al. (2011)
worked on the financial practices and provided a descriptive analysis in corporate
sector of Pakistan. Cowton & Pilz (1995) focused on retailing sector and employed
investment appraisal techniques, while Morgan & Tang (1992) concentrated on
distribution and financial services. Financial practices are discussed and analyzed
4
separately (by including one or two practice only) by researchers, but collectively,
only few researchers have examined these practices. In addition, there is a need of
comprehensive analysis to determine the perception about practices and level of
implications in corporate sector. Since financial managers, financial executives and
financial analysts believe that these practices are very important for the improvement
of firm performance, if appropriately practiced, which can also play a critical role in
the development of firms (Hunjra et al., 2011). In addition, it is necessary to explain
the role of financial practices for the betterment of firm performance (Morgan &
Tang, 1992; Cowton & Pilz, 1995; Hunjra et al., 2011).
1.3
Financial Practices
1.3.1
Capital Structure Decisions
Capital structure of a firm consists of debt and equity proportions and it can
be referred to financial framework of a firm. In addition, it has always been popular
among scholars of financial studies (Myers, 1984; Heng & San, 2011). One can drive
the significance of capital structure from the fact that basic purpose of capital
structure is to fulfill the needs of various stakeholders. Therefore, development of
new theories on optimal capital structure started from the last century and economic
world was surprised when Modigliani and Miller (1958) came up with their
irrelevance theorem of capital structure. They claim that under certain circumstances,
the value of the firm is independent of its financial structure. However, institutional
environment and firm‘s characteristics are the major determinants in the selection of
optimal structure (Allayannis et al., 2002; Marques & Santos, 2003; Grundströmer &
Gustafsson, 2007; Antoniou et al., 2008; Pratheepkanth, 2011). Capital structure
occupies the decisions regarding different sources of funding1, which are useful to
1
Sources of fund includes preferred stock and common stock called equity financing while long term debt
finance, short term debt finance called debt financing
5
enhance the performance and firm needs for various sources of fund to finance its
investments as well as business operations (Saeedi & Mahmoodi, 2011). Therefore,
decisions about capital structure (debt/equity) are significant for value, growth and
better performance of a firm (Antoniou et al., 2008; Akintoye, 2008; Arbabiyan &
Safari, 2009; Frank & Goyal, 2009; Al-Taleb & Al-Shubiri, 2011).
1.3.2
Dividend Policy Decisions
Dividend policy is related to proper distribution of firm‘s profit into
shareholders (Marfo-Yiadom & Agyei, 2011). Since the controversy of capital
structure, Miller & Modigliani (1961) initiated the importance of dividend policy or
payout decisions. They established the fact that without market imperfections (e.g.
transactions costs and taxes); dividend policy has no impact on firm‘s performance.
In addition, Black (1976) appropriately referred this argument as ―dividend puzzle‖
and the argument of irrelevance becomes more popular in the debates among
researchers. Therefore, firms have to decide the proportions of earnings, how much
to pay shareholders and how much to retain for further investment from the profit of
a firm (Marfo-Yiadom & Agyei, 2011). Consequently, there are some factors in the
business environment, which gradually become antecedents of dividend policy
(Adefila et al., 2004). These factors (determinants) include previous dividend,
profitability, dividend signaling, current year earnings, firm size, ownership
structure, age, risk, dividend changes and firm growth (Baker et al., 2007; Archbold
& Vieira, 2008; Jeong, 2008; Fodio, 2009; Hunjra et al., 2011; Khan et al., 2011).
Managers use dividends as a source of information signaling related to future growth,
earnings and performance of firm (Redding, 1997; Lazo, 1999). Generally, dividend
policy decisions are considered very important for firm growth and have significant
impact on performance (Amidu, 2007; Foong, Zakaria & Tan, 2007; Azhagaiah &
Sabari, 2008; Al-Najjar & Hussainey, 2009a; Drnevich, 2011; Geng & Liu, 2011;
Marfo-Yiadom & Agyei, 2011).
6
1.3.3
Investment Appraisal Techniques
Investment appraisal techniques are generally most surveyed topics in
corporate finance, in the terms of financial practices (see, e.g. Sangster, 1993;
Mccaffarey et al., 1997). The fundamental purpose of investment appraisal
techniques is to determine the long-term investment decisions (e.g. new machinery,
replacement of machinery, research development projects, new plant, and new
product) of a firm are worth hunting. Therefore, it would not be wrong to say that
these techniques determine the budget for capital investments or capital expenditures
(Seteven, 2003). In area of financial practices, investment appraisal techniques are
very important although these techniques have some issues related to forecasting
(Akalu, 2001; Hunjra et al., 2012). However, from fundamentals of investment
techniques, risk analysis is one of them (Akalu, 2001). In investment appraisal
techniques, mostly used and accepted techniques include basic techniques2 and
discounted cash flow techniques3, which are based on time value of money
(Farragher, Kleiman & Sahu, 1999; Liljeblom & Vaihekoski, 2004; Kantudu, 2007;
Akinbuli, 2011). Although, for selection of techniques, firms should follow a proper
selection procedure, as Farragher et al. (1999) explained that for the effective and
successful capital expenditure, it is necessary to make some plans. While selecting a
suitable technique for investment appraisal, one should keep in mind these plans (e.g.
strategic analysis, investment goals, investment opportunities, forecasting cash flow,
evaluating the risks) (Akalu, 2002; Milis et al., 2009; Afonso & Cunha, 2009).
Therefore, vigorous investment appraisal techniques are very important for firm
because these help the managers in ranking and selecting the best-suited projects.
These techniques are very significant for a firm‘s growth, value and performance
(Arnold, 1998; Drury, 2000; Olawale et al., 2010; Halttunen, 2012).
2
Payback Period (PB) and Accounting Rate of Return (ARR) are the basic investment appraisal techniques.
Internal Rate of Return (IRR), Net Present Value (NPV) and Profitability Index (PI) are the discounted cash
flow techniques.
3
7
1.3.4
Working Capital Policy
The debates on capital structure decisions and dividend policy as well as
investment appraisal techniques are related to long-term decisions of a firm
(Mccaffarey et al., 1997; Hunjra et al., 2011), while working capital policy deals in
management of operations of firm (mature within one year), liabilities and assets
(Mccaffrey et al., 1997; Hayajneh & Yaseeni, 2011). Therefore, almost every firm
follows two types of working capital policies, aggressive policy and conservative
policy. In aggressive working capital policy, firms take high risk for high profit by
investing fewer amounts in current assets (Weinraub & Visscher, 1998 and Gardner
et al., 1986). This policy includes high risk because of the creditor who might claim
for money and due to some reasons, firms are unable to settle creditor‘s claim, so it
might create trouble for firms (Weinraub & Visscher, 1998; Nazir & Afza, 2009).
For avoiding such kinds of dilemmas, it would be better for business to adopt
conservative working capital policy. The advantage of this policy is that firm keeps a
balance between current assets and current liabilities, and keeps protection to
overcome any uncertain condition (Pinches, 1994). This policy can be very useful for
firm in reducing risk but it decreases the opportunity of increasing production by
decreasing available amount for firm (Teruel & Solano, 2007; Gill et al., 2010; Niazi
et al., 2011; Qazi et al., 2011). Many researchers (e.g. Afza & Nazir, 2007; Nazir &
Afza, 2009; AL- Shubiri, 2011) have documented that working capital policy has
strong impact on performance of a firm. The significance of working capital policy
can be analyzed through the fact that it has strong effect on firm profitability. In
addition, such risk affects the value and growth of a firm but working capital policy
reduces that risk and enhances the performance (Smith, 1980).
1.3.5
Methods of Measuring Cost of Capital
In financial practices, methods of measuring cost of capital (MMCOC) are
also very important for firms (Graham & Harvey, 2001). The definition of cost of
capital is that it is a required rate of return by firm in order to meet the expense of
8
generating finance in the markets (Al-Mutairi, 2011). In financial practices,
investment decision making is very critical task (Kester et al., 1999). Investing in a
new project needs capital and this capital might bring some costs. It is difficult to
find out that source of finance has cost or not, because every source of finance may
or may not impose some cost on company (Rajatanavin & Venkatesh, 2007).
Therefore, in these managerial decisions-making fields, some methods are used to
calculate the cost of capital (Benetti, Decourt & Terra, 2007; Chazi, Terra & Zanella,
2010). These methods include weighted average cost of capital (WACC), capital
asset pricing model (CAPM) and dividend discount model (DDM). In these methods,
CAPM is a popular method in firms for calculating cost of capital (Kester et al.,
1999; Graham & Harvey, 2001; Brounen, De Jong & Koedijk, 2004). However, in
corporate finance decisions, impact of methods of measuring cost of capital on firm‘s
performance is very important because it is hard to estimate the accurate cost of any
source of financing. Consequently, it is certain that high cost of capital has negative
impact on performance of a firm (Bacidore et al., 1997; Firer et al., 2004; Vázquez &
Trombetta, 2007; Rehman & Zaman, 2011).
1.3.6
Financial Assessment using Financial Ratios
Financial assessment of a firm is very vital in financial practices; hence,
financial assessment ratios are used as instruments to determine whether firm‘s plans
make financial sense (Horta et al., 2012). Therefore, evaluation of a business
accurately plays a key role in the success of a firm. In the strong competitive
environment of 21st century, it is significant for a firm to have considerable financial
and non-financial structure4. In the old times (before 21st century), financial
statements (income statements and balance sheets) were managed manually on
annual basis and were used for assessing the performance of a firm (Mccaffarey et
al., 1997). The assessment of performance is planned and survival of a firm in long
run depends upon the performance. Therefore, for measuring the overall prosperity
4
Financial and non-financial organization‘s structure includes efficient management, rapid response, high quality
services and products.
9
of a firm, managers use performance assessment (Brigham & Ehrhard, 2005).
Generally, financial performance is related to the revenue of a firm that how to
generate profit by utilizing assets efficiently and effectively (Bashir, 2003). The term
performance assessment provides the overall financial health of a firm and can be
used in the comparison of similar firms across the same industry (Kaplan & Norton,
1996). However, performance can be defined in the form of growth, value, profit,
output, productivity, brand image, sales etc (Almazari, 2011). Over the years, many
tools and techniques have been developed for analyzing and judging the financial
performance of a company (Palepu et al., 2000). One of the most popular tool to
evaluate these aspects is financial ratios assessment. Prior researchers (e.g.,
McCaffery et al., 1997; Jahangir, Shill & Haque, 2007; Prasetyantoko & Parmono,
2008; Marimuthu, 2010; Ong, Teo & The, 2011; Memon & Tahir, 2012), evaluated
the performance by using financial ratios persistently. These ratios include Price per
Earnings ratio (PE), Return on Assets (ROA), Sales/Total Assets (STA), Cash Ratio
(CR), Earnings Per Share (EPS), Return on Equity (ROE), Times Interest Earned
ratio (TIE), Profit Margin/Total Assets (PMA), and Debt per Equity Ratio (D/E).
Moreover, financial assessment by using financial ratios has shown strong positive
impact on firm performance (Sufian, 2007; Niazi et al., 2011; Ong et al., 2011;
Singh, 2011).
1.3.7
Agency Cost
Economic concept of agency cost is defined as, the cost of hiring or selecting
an agent (manager, management etc) by principal (firm, person, group of persons,
etc) to work on its behalf (Jensen, Solberg & Zorn, 1992; Hall, 1998). This cost
arises due to the conflict of interest between principal and agent because agent has
more knowledge about the firm and market conditions. Therefore, it is hard for
principal to measure the activities of agent5 (Myers, 2000). There are mostly two
types of agency costs in business environment, agency cost of capital structure
(debt/equity) and agency cost of dividend policy (free cash flow). Agency cost of
5
Such activities, which are not in the interest of principal but in the interest of agent.
10
capital structure arises due to the conflict of interest between shareholder and
management. Shareholders will have to bear this cost as long as the interest of
management differs from shareholders (Brigham & Gapenski, 1993). On the other
hand, the agency cost of debt occurs due to the conflict of interest between debt
holders and shareholders (Khan et al., 2012). The debt-holders put some restrictions
on firm while providing a debt because they want to secure their interest in the firm.
They feel a threat from the management and shareholders. Similarly, interest of
management and shareholders is against the debt-holders because management can
transfer money to shareholders in many ways and leave the debt-holder without
interest. Easterbrook (1984) and Jensen (1986) presented the agency cost of free cash
flow and they argued that free cash flow available in firms is also responsible for
agency cost (Yermack, 2006; Zhang, 2009). After paying all the obligation of firm,
management can utilize the free cash for its own interest instead of distributing it to
shareholders, and this action of management is against the interest of shareholders
(Jensen, 1986). In this situation, dividend payment plays a positive role in reducing
the agency cost; higher dividend payment reduces the available free cash flow to
management and expects to reduce the agency cost (Rozeff, 1982; Lozano et al.,
2005). Moreover, higher payments of dividend are also an indicator of better future
performance, growth and profit of firm (Litzenberger & Lang, 1989; Utami &
Inanga, 2011). Therefore, many researchers documented the impact of agency costs
on capital structure decision, dividend policy as well as on firm‘s performance
(Lasfer, 1999; Jong & Dijk, 2002; Byrd, 2010; Stephan et al., 2011; Bell, 2012).
1.4
Stock Markets in Pakistan
The economy of Pakistan is the 26th largest economy in the world in terms
of purchasing
power
parity (PPP),
and 44th
largest economy
in
terms
of
nominal Gross Domestic Product (GDP), even though the country is sixth most
populous country in the world. As Pakistan has a population of over 186 millions
(the world's 6th-largest), thus GDP per capita is $3,149 ranking 140th in the world.
Pakistan is a developing country and is one of the next eleven, the eleven countries
11
that have a potential to become one of the world's large economies in the 21st
century (KSE Articles, 2015).
In contemporary market dominated economic system, stock market performs
a key role by mobilizing the financial means from savers to the potential investors
(Mala and White, 2006; Shahbaz et al., 2008). An active equity market plays an
important role in forecasting the economic growth of a country and is treated as a
barometer of the economy (Singh, 2011). It exhibits the capital growth, saving and
investor‘s faith in financial sector. Capital market being the most prominent
component of financial system drives the financial strength through effective
resource mobilization and consequently influences the economic growth and
development of a country (Buyuksalvarci, 2010).
Pakistan comprehended the worth of equity market by setting up Karachi
Stock Exchange (KSE) in 1949. In Pakistan, equity market principally reflects three
stock markets, which are: (i) Islamabad Stock Exchange 10-Index, (ii) Karachi Stock
Exchange 100-Index, (iii) Lahore Stock Exchange 25-Index. KSE is the largest and
oldest of three exchanges in Pakistan since its inception (Nishat and Shaheen, 2004;
Uppal and Mangla, 2006). At the start, KSE was measured by KSE-50 Index and
there were seven companies listed on KSE with paid-up capital of Rs. 37 Million
(KSE Articles, 2015). KSE is the most prominent equity market in Pakistan as it
reflects almost 85% of the total turnover in the country (Javed, 2008). Initially, stock
market in Pakistan was regulated by Corporate Law Authority (KSE, 2011). Asian
Development Bank (ADB) introduced a plan in 1997, which involved the
improvements of existing Corporate Law Authority. Hence, parliament approved and
formally proclaimed the Act of Security and Exchange Commission of Pakistan
(SECP) in December 1997 and consequently SECP replaced the Corporate Law
Authority and started functioning from January, 1999, onward. In Pakistan, equity
market improved significantly after the commencement of KSE as it emerged as a
most important institution of capital formation in Pakistan and is voted as the most
strongly performing market in Asia (Javed, 2008; ADB Report, 2008).
12
During the last decade, improvements in regulatory framework have
motivated the local as well as foreign investors to make investments and the stock
market has achieved exceptional performance (IMF Country Report, 2010). On
December 31, 2014, 557 companies were listed on KSE, with average market
capitalization of Rs.7380531 million (US$72287.3 million) (Economic Survey,
2013-2014). The companies listed at KSE have been classified into 34 sectors,
representing almost all sectors of Pakistan‘s economy. Authorities have taken
number of steps to improve the operations of capital market for enhancing the
progression and solidity of financial sector and capital market in Pakistan (Javed,
2008). These steps included, implementing the code of corporate governance,
establishing code of conduct for brokers, controlling through circuit breakers,
electronic entry book system, no restriction on transfer of dividend and capital gain,
no prior approval for issuance and transfer of shares to the foreigners, and setting up
a National Clearing Company to promote clearing and settlement activities (Osei,
1998; Javed, 2008; IMF Country Report, 2010). These improvements generated
returns and contributed to the economic growth through strengthening the economic
and financial forces (Hondroyiannis et al., 2005; Nieuwerburgh et al., 2006).
Table 1.1: List of Companies with Market Capitalization
Years
2010
2011
2012
Listed Companies
644
638
573
Listed Capital (Rs in
919.26
1,048.87
1,094.40
million)
Market Capitalization
3,268.95
2,945.71
4,242.4
(million)
New
Companies
6
4
4
Listed
Listed Capital (in
33,438.45 16,010.82 8,161.04
million)
Source: Karachi Stock Exchange (www.kse.com.pk, 2015)
2013
560
2014
557
1,129.82
1,168.89
6,056.50
7,380.74
3
6
4,545.07
26,973.48
In Pakistan, stock market has shown exceptional performance from 2005-06
to 2007-08 but has started to decline from mid of 2008 onward due to global
financial crisis coupled with the decline in domestic economic indicators (IMF
Country Report, 2010). Figure 1.1 shows rise in KSE-100 index from 2005-06 to
2007-2008; however, from the mid 2008 onward, as the global financial crisis starts
13
affecting Pakistan, downward trend in KSE-100 index is observed. As at the end of
March 2008, the aggregate market capitalization on KSE stood at $56 billion, which
dropped to just $20 billion on January 2009, showing a significant decrease of $36
billion (Economic Survey, 2008-09). However, over the last four years (2011 to
2014) improvement in the performance (increase in market capitalization and
profitability) of banking, oil and gas, chemical and personal goods attracted the
foreign investors; which consequently has improved the KSE-100 index (Economic
Survey, 2013-2014).
18000
16000
14000
12000
10000
8000
6000
4000
2000
0
Column2
Column1
Series 1
2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Figure 1.1 KSE 100 Index (2015). Source: www.kse.com.pk
It is clear from the debate on financial practices that the role of finance is
very vital for managers, investors and financial analysts in decision-making process.
It helps the managers in selecting and implementing financial practices properly.
However, financial practices have strong impact on firm‘s performance but these
practices are mostly followed in developed countries because market conditions of
developed countries are much better than those of developing countries. Markets are
perfect and working properly in developed countries, but in developing countries,
scenario is different. Particularly to Pakistan, being a 26th largets economy in the
world and having one of the excellent stock exchanges in the world, still the
economic situation is not satisfactory. It is vital to determine the association between
financial practices and the performance of various industries on stock market. This
study is useful to develop an improved and effective economic policy for the growth
and development of the economy.
14
1.5
Problem Statement
Corporate sector has a vital role in the growth and development of economy.
It is clear from the literature that financial practices are very important, and
management should concentrate on the proper utilization of these practices in
decision-making (Pinegar & Wilbricht, 1989). Past studies on financial practices
(e.g. McCaffery et al., 1997; Graham & Harvey, 2001; Brounen et al., 2004;
Rajatanavin & Venkatesh, 2007; Al-Mutairi & Hasan, 2011; Hunjra et al., 2011) are
evident that these practices are reviewed in different sets of clauses. McCaffery et al.
(1997) reviewed capital structure decision, dividend policy decision, investment
appraisal techniques, working capital policy, and financial assessment using financial
ratios. Graham & Harvey (2001) examined investment appraisal techniques, cost of
capital, and capital structure decision. Al-Mutairi & Hasan (2011) investigated
investment appraisal techniques, cost of capital, capital structure decision and
dividend policy decision. Importantly, most of the prior studies have been conducted
in developed countries and these studies have provided descriptive analysis (see:
appendix A). In addition, these studies have not investigated the relationship between
financial practices and firm‘s performance.
Financial practices are commonly followed in developed countries as
compared to those in developing countries. In financial practices, capital structure
decisions are very critical for the growth of a firm (Al-Mutairi, 2011). Therefore,
managers always try to find out an optimal capital structure (debt/equity ratio) but it
is very difficult to develop optimal capital structure due to its complex nature.
However, there is still need to identify the optimal or near to optimal capital structure
(Kumar, Anjum & Nayyar, 2012). Financing and investment decisions are significant
in financial sector but these decisions are not evaluated properly (McConnel &
Servaes, 1990). In the evaluation of financing and investment decisions, investment
appraisal techniques are useful. These techniques have various concerns since
management objective and constraints are very critical in appraisal process. In
addition, investors are not conscious about the significance of appraisal techniques in
firm‘s performance (Morgan & Tang, 1992) and they have no idea how to utilize
these techniques properly (Akinbuli, 2011). Firms should find out a coordination
15
between net cash flow or operations of firm (short-term assets and liability
management) to reduce the threat of potential problems (liquidity, bankruptcy, shortterm fluctuations etc.). According to Bei & Wijewardana (2012), demographics
changes of firm and market systematic factors (e.g. demand, supply etc.) have impact
on working capital policy. Moreover, different working capital policies are
differently affecting the firm‘s performance due to the structure of firm and market
conditions. Working capital policy can increase the firm performance but Palani &
Mohideen (2012) documented that only few studies have been conceded to inspect
this relationship by using primary data analysis. Thus, more research is needed to
highlight the important of working capital in firm growth.
Methods of measuring cost of capital are major standards that help in the
assessment of different financial sources. It also assists in accepting and rejecting an
investment proposal, since it estimates the financing cost, which a firm must have to
pay. However, which method is significant in forecasting the accurate cost of capital
is still a puzzling issue for management (Kumar, Anjum & Nayyar, 2012). As, most
of the firms rely on their experience and capital assets pricing model (CAPM) to
evaluate the cost of capital because there is a lack of awareness on new methods like
internal rate of return, weighted average cost of capital and project dependent cost of
capital (Hunjra et al., 2012).
There are some factors prevailing in the surrounding environment of the firm,
which have great impact on financial decisions of a firm (Antoniou et al., 2008).
Agency cost is one of these factors, which have great impact on financial decisions
especially decisions related to capital structure and dividend policy (Smith &
Warner, 1979; Jensen & Meckling, 1976; Myers, 1977). Agency cost is borne by
shareholder to encourage the management to work in the favorer of their wealth
maximization. Agency costs are crucial for firm and shareholders, because
shareholders bear losses if management works for its own incentive and
remunerations, or may invest in non-profitable projects instead of maximizing the
shareholder wealth. On the other hand, debt-holders must bear losses if management
considers the value maximization of shareholder and abandon the debt-holder.
Therefore, it is very significant to find out a way to settle the agency problems. In
16
this context, most of the prior studies (e.g. Berger & Di-Patti, 2006; Brockman &
Unlu, 2009; Caelers, 2010; Khan et al., 2012) documented the relevancy of agency
costs in capital structure decision and dividend policy but regarding the relationship
between agency costs and capital structure, previous studies are comparatively
inadequate (Tsuji, 2011). Similarly, the agency costs of debt and free cash flow have
been widely discussed (Gonenc, 2005), but the affects of free cash flow (FCF) cost
on firm‘s performance have not been examined (Al-Taleb, 2012). Therefore, this
study is used agency cost as a moderator to highlight the impact of agency cost on
the firm performace.
In Pakistan, Karachi Stock Exchange (KSE) is the largest and the oldest stock
exchange, which is measured through KSE-100 index. KSE has made many
achievements and remained among the top exchanges round the globe in terms of
performance, though has declined over the last few years (IMF Country Report,
2013). KSE delisted more than 110 companies in the last four years and the common
reason was that these companies were not paying dividends regularly. Moreon, some
of the delisted companies faced bankruptcy due to lack of efficient financial policies.
As, studies on Pakistani corporate sector state that most of the private and public
firms do not follow financial practices due to lack of awareness regarding financial
practices (Niazi et al., 2011). Moreover, Pakistani firms do not properly employ any
working capital policy and there is a need to explore the role of working capital
policy in firm‘s performance (Hussain, Farooq & Khan, 2012). Agency cost is an
essential issue in the business environment, which has strong impact on financial
practices especially capital structure decision and dividend policy decision as well as
on performance of the firm (Antoniou et al., 2008). A study by Hunjra et al. (2012)
on Pakistani corporate sector also indicates that financial practices are not being
practiced properly in firms. Importantly, there is less understanding concerning
application of these practices and their role in firm performance.
17
1.6
Research Questions
Descriptive and empirical investigations (e.g. see McCaffery et al., 1997;
Graham & Harvey, 2001; Benetti et al., 2007; Rajatanavin & Venkatesh, 2007;
Chazi et al., 2010; Al-Mutairi & Hasan; Hunjra et al., 2011) show that proper
utilization of financial practices leads to growth and stability of a firm. Financial
practices are very significant for the success (performance) of the firm (e.g. see AlMutairi & Hasan; Hunjra et al., 2011). Therefore, the purpose of this study is to
investigate the application of financial practices and its impact on firm performance
as well as moderating role of agency cost. Specifically, to examine the following
issues:
1. What are the financial practices currently being practiced among firms in
Pakistan?
2. What is the empirical relationship between financial practices and firm
performance?
3. Does agency cost moderate the relationship between capital structure
decisions and firm performance?
4. Does agency cost moderate the relationship between dividend policy
decisions and firm performance?
1.7
Research Objectives
Zikmund (1997; p37) explained the objectives of research as Researcher‘s
version of business problem is the objective of research and it explains the purpose
of research in measurable terms as well as defines the standard of what the research
should accomplish. Identifying the application of financial practices and their impact
on firm performance as well as interactive role of agency cost and its relationship
18
with performance is the central objective of this study. Other objectives of this study
are follows:
1. To explore the financial practices which are currently being practiced among
firms in Pakistan.
2. To investigate the effect of financial practices on firm performance.
3. To examine the moderating impact of agency cost on the relationship
between capital structure decisions and firm performance.
4. To inspect the moderating impact of agency cost on the relationship between
dividend policy decisions and firm performance.
1.8
Significance of the Study
This study attempts to measure the application of financial practices in
Pakistani corporate sector. These financial practices include capital structure
decision, dividend policy decision, investment appraisal techniques, working capital
policy, methods of measuring cost of capital and financial assessment using financial
ratios. The proposed research investigates the effect of financial practices on firm
performance as well as investigates the moderating effect of agency cost on the
relationship of capital structure decisions and dividend policy decisions with firm
performance. This study is significant from theoretical and practical perspectives;
from a theoretical perspective, it brings reflective insights related to corporate
finance theories (theories of capital structure decision and dividend policy decision)
and agency problem theory particularly in context of an emerging market, i.e.
Pakistan. Emerging markets are different from developed markets and factors that
affect performance in emerging markets could be different from the ones that affect
firm performance in developed markets. Therefore, this study provides a useful
investigation whether theories of capital structure decision, dividend policy decision
19
and agency cost that have been followed in developed markets are applicable in
emerging markets (e.g. Pakistani markets). From a practical perspective, there is a
lesson from findings of the research that guides to improve the managerial practices
and financial decisions as well as their contributions to corporate performance. The
finding of this study from listed companies on Karachi Stock Exchange (KSE) could
provide a useful template for future research in other emerging and developing
markets.
Most of the prior survey studies (i.e. McCaffery et al., 1997; Graham &
Harvey, 2001; Brounen et al., 2004; Benetti et al., 2007; Cohen & Yagil, 2007;
Rajatanavin & Venkatesh, 2007; Chazi et al., 2010; Al-Mutairi & Hasan, 2011;
Hunjra et al., 2011) have not employed comprehensive set of financial practices. The
study of McCaffery et al. (1997) covers five practices: capital structure decision,
dividend policy decision, investment appraisal techniques, working capital policy
and financial assessment using financial ratios. The study by Graham & Harvey
(2001) examined investment appraisal techniques, cost of capital and capital
structure decision. Brounen et al. (2004) presented an international survey on
investment appraisal techniques, methods of measuring cost of capital and capital
structure decision. Benetti et al. (2007) investigated the application of cost of capital,
investment appraisal techniques and capital structure decision. Al-Mutairi & Hasan
(2011) examined investment appraisal techniques, methods of measuring cost of
capital, capital structure decision and dividend policy decision. Notably, existing
studies have not investigated the relationship between these practices and firm
performance. Therefore, focus of this study is broad, which employs all the financial
practices like capital structure decisions, dividend policy decisions, investment
appraisal techniques, working capital policy, methods of measuring cost of capital,
and financial assessments using financial ratios with moderating role of agency cost.
This study used inferential statistics in data analysis as the proposed research
investigates the relationship between financial practices and firm performance.
Hence, this study provides better understanding of financial practices and their
impact on firm performance.
20
In financial practices, the concept of cost of capital is crucial since there are
various misconceptions present about this concept (Kester et al., 1999). A number of
studies (e.g. Bacidore et al., 1997; Firer et al., 2004; Vázquez & Trombetta, 2007;
Rehman & Zaman, 2011) documented the importance of cost of capital in
minimizing the risk of extra financing source cost. However, how a firm chooses a
method to determine the reasonable amount of cost of capital and which method is
better, is still a riddle (Kumar, Anjum & Nayyar, 2012). As Hujra et al. (2012)
claimed that their work is pioneer in financial practices in Pakistan and they paid no
attention on the importance of methods of measuring cost of capital. Therefore, this
study intends to explore the methods, which are currently being pursued in
calculating the cost of capital, and preference of the management regarding selection
of method. Moreover, this study aspires to inspect the role and significance of
methods of measuring cost of capital in firm performance. This study provides the
better understanding to management on methods of measuring cost of capital and
helps them in selection of methods.
A number of previous studies (e.g. Berger and Di-Patti, 2006; Brockman &
Unlu, 2009; Caelers, 2010; Khan et al., 2012) have explained the effective role of
agency cost in decision-making of capital structure decision and dividend policy
decision. Several studies (e.g. McKnight, 2008; Zhang, 2009; Byrd, 2010; Utami &
Inanga, 2011; Al-Taleb, 2012) documented that agency cost (AC) negatively affects
the capital structure decision and dividend policy decision. However, there is a need
to identify the interactive role of AC and regarding the impact of AC on capital
structure decision and dividend policy decision empirical studies are relatively
insufficient (Tsuji, 2011). There are several kinds of AC, one of them is agency cost
of free cash flow, which is also very important. The AC of debt and free cash flow
have been widely discussed but effects of FCF cost on firm‘s performance have not
been investigated (Al-Taleb, 2012). Agency costs also exist in the developing
countries like Pakistan at big level but studies who examined the agency cost are
fewer in number (Gul et al., 2012). In addition, in Pakistani profitable corporation,
free cash flow is under the control of managers and they do not utilize the cash for
the development of firm (Khan et al., 2012). Therefore, this study aims to examine
the moderating role of agency cost and its impact on the relationship of capital
21
structure decisions and dividend policy decisions with firm‘s performance. This
study helps the management in selecting dividend policy and capital structure to
minimize the agency cost.
The literature review points out the existing gap in understanding the issues
of financial practices, moderating role of agency cost and their impact on firm‘s
performance. In addition, the emerging markets evidence is limited, for example,
Hujra et al. (2012) claim that their research on financial practices especially
investment appraisal techniques is a pioneer study in the context of Pakistan. They
documented that financial practices are important for the growth of firm. On the
other hand, Gul et al. (2012) documented that their study is pioneer work in the
context of Pakistan, which addresses the agency problems. Therefore, this research
adds to body of knowledge of financial practices through providing an opportunity to
contribute to overall performance of corporate sector. Moreover, this study gives
voices to potential companies‘ managers by providing them an opportunity to
contribute to overall performance of the firm in terms of agency costs related
decisions. This study provides evidence on the importance of the relationship
between financial practices and firm‘s performance. From a theoretical significant
perspective, this study fills a gap in understanding the perceptions of different
stakeholders groups of firms related to agency costs issues.
This study explores the significant role of various techniques and methods
that are used in financial practices and firm performance. In addition, this study also
investigates the impact of AC on the relationship of capital structure decision and
dividend policy decision with performance of a firm. Therefore, this study helps the
financial analysts in selection and implementation of particular techniques, which
significantly contribute in the performance of the firm as well as help in minimizing
the agency cost. Moreover, it is hard for a firm to borrow money from financial
institutions (e.g. banks, loan companies etc.) since the performance of the firm does
not match the criteria of their policies. Therefore, this study provides an insight into
firm and explores various financial techniques, which will enhance the performance
and firm can easily borrow money from financial institutions. In government firms,
financial practices are not followed properly since they are not aware of the
22
importance of these practices in firm‘s performance. This study discloses the vital
role of financial practices in firm performance and provides the evidence on the
significance of financial practices.
1.9
Scope of the Study
This research is a survey study on application of financial practices in
corporate sector and its impact on performance of a firm in the current economic
conditions of Pakistan. This study can be generalized to the other economies keeping
in sight their own country specific factors of corporate sector. Particularly, this study
investigates, which financial practices are being carried out and at what extent in
Pakistani corporate sector. In this study, primary data is used in measuring the
financial practices, agency cost and firm performance. This study chooses financial
and non-financial firms, which are listed in Karachi Stock Exchange (KSE). More
than 650 financial and non-financial firms are listed on KSE and out them 350 firms
are selected (based on the dividend policy of firms) by this study. These firms follow
financial practices, since, not all firms follow financial practices properly. Most of
the prior studies on financial practices are conducted in developed countries and
these studies provide only descriptive findings of financial practices. This study
investigates the application of financial practices and their impact on firm
performance in developing market. In addition, this study examines the moderating
role of agency cost on the relationship of capital structure and dividend policy with
firm performance.
1.10
Operational Definitions
Followings are the operational definitions of variables considered for this
research.
23
1.10.1 Financial Practices
Financial practices involve any decision made by managers that have any
financial implication on operation of the business.‖ (Al-Mutairi, 2011; p1)
1. 10.1.1 Capital Structure Decisions
The capital structure is how a firm finances its overall operations and growth
by using different sources of funds. Debt comes in the form of bond issues or longterm notes payable, while equity is classified as common stock, preferred stock or
retained earnings (Pratheepkanth, 2011; p2).
1. 10.1.2 Dividend Policy Decisions
A dividend policy is a company's approach to distributing profits back to its
owners or stockholders. If a company is in a growth mode, it may decide that it will
not pay dividends, but rather re-invest its profits (retained earnings) in the business
(Amidu, 2007; p104).
1. 10.1.3 Investment Appraisal Techniques
Investment appraisal is the planning process used to determine whether an
firm's long term investments such as, new machinery, replacement machinery, new
plants, new products, and research development projects are worth the funding of
cash through the firm's capitalization structure (debt, equity or retained earnings). It
is the process of allocating resources for major capital, investment and expenditures
(Chrysafis, 2012; p1042).
24
1.10.1.4 Working Capital Policy
It is a measure of both a company's efficiency and its short-term financial
health. The working capital ratio (Current Assets/Current Liabilities) indicates
whether a company has enough short term assets to cover its short term debt
(Appuhami, 2008; p9).
1. 10.1.5 Methods of Measuring Cost of Capital
Cost of capital refers to the opportunity cost of making a specific investment.
It is the rate of return that could have been earned by putting the same money into a
different investment with equal risk. Thus, thecost of capital is the rate of return
required to persuade the investor to make a given investment (Nel, 2011; p5337).
1.10.1.6 Financial Assessment using Financial Ratios
It is a process of evaluating businesses, projects, budgets and other financerelated entities to determine their suitability for investment. Typically, financial
analysis is used to analyze whether an entity is stable, solvent, liquid, or profitable
enough to be invested in (Wen, 2010; p3).
1.10.2 Agency Cost
It is a type of internal cost that arises from, or must be paid to, an agent acting
on behalf of a principal. Agency costs arise because of core problems such as
conflicts of interest between shareholders and management (Cohen & Yagil, 2006;
p179).
25
1.10.3 Firm Performance
A subjective measure of how well a firm can use assets from its primary
mode of business and generate revenues. It is a general measure of a firm's overall
financial health over a given period of time, and can be used to compare similar
firms across the same industry or to compare industries or sectors in aggregation
(Graham & Harvey, 2001; p21).
1.11
Organization of Thesis
Aspire of this particular study is to examine the application of financial
practices in Pakistani corporate sector and its effect on performance of firm as well
as the moderating role of agency cost. The proposed thesis is projected into five
chapters, which demonstrates and adds towards research streams of financial
practices, firm‘s performance and agency cost add to different analysis tools.
Moreover, all chapters of this thesis are prepared and intimately allied on each other.
In addition, all characteristics, which have argued in each chapter, are essential parts
for the erection and implementation of a theoretical gallows on how efficiently
financial practices can utilize for the betterment of the firm‘s performance.
In this study, first chapter ‗Introduction‘ presents the financial practices and
their impact on firm performance as well as the moderating role of agency cost. The
chapter has the background of the study, which includes the importance of finance in
decision making of financial practices and importance of these practices in firm‘s
performance. Moreover, acknowledgement of problem statement, questions of
research, objectives of research, significance of the study, scope of this research and
operational definitions of variables are included in this chapter.
Chapter two of this study provides a review of the prior studies on the
application of financial practices and importance of agency cost. Chapter 2 covers
26
necessary theoretical background and empirical support for the thesis. Afterward in
this chapter, concluding remarks and outcome of this literature review of earlier
survey studies is covered.
In this particular thesis, research methodology outlines, research framework,
research model and hypotheses of this study are presented in chapter three for the
anticipated interconnectivity of the financial practices and firm performance along
with interactive role of agency cost. This chapter also discloses the types of research,
data collection methods, data sampling, data analysis techniques, mathematical
model, verbal model and statistical tools that are used for inspecting the relationship
between financial practices and performance of firm as well as the moderating effect
of agency cost.
In this proposed study, all the results of data collection, analyses and results
in detail are displayed in chapter four. Results are associated with the hypotheses
established in chapter three. Moreover, all results of the relationship between
financial practices and performance of firm along with moderating effect of agency
cost are wrapped up in chapter five.